Friday, January 6, 2012

As detailed here, the biggest source of error in my predictions for 2011 was my belief that the economy would be somewhat stronger than expected, and that this, coupled with higher-than-expected inflation, would force the Fed to raise interest rates sooner than the market expected. I got the inflation part right, but the economy proved weaker than both I and the market expected. That in turn prompted the Fed to promise very low rates for a very long time, thereby collapsing interest rates across the maturity spectrum. The weak economy coupled with the Fed's extreme measures to resuscitate it, plus the growing likelihood of sizable sovereign debt defaults in the Eurozone, helped convince the market that the situation was dire. So now the key question, from the market's perspective, is whether the economy can avoid a calamity.

I say this because I observe that the market today is even more fearful about the future than it was a year ago. I see that in 2-yr Treasury yields of 0.25%, which say that the market fully expects the Fed funds rate to be extremely low for at least the next two years; that is likely to happen only if the economy remains in miserable shape and inflation remains relatively low. I see it in 10-yr Treasury yields, which are as low as they were in the depths of the Depression, and lower even than they were at the end of 2008, when panic reigned. I see it in equity PE multiples that are only marginally higher than they were at the end of 2008, when the market was priced to a global depression and years of deflation. Equity multiples have declined over the past two years even as corporate profits have soared to all-time highs; the only way this makes sense is to assume that the market believes growth will be abysmal and profits will collapse in coming years. I see fear in credit spreads that are as high or higher than they have been prior to previous recessions. I see tremendous uncertainty in gold prices that have risen by a factor of 6.5 over the past 10 years, a sure sign that investors have lost almost all confidence in the ability of the global economy to grow, and in the ability of central banks to successfully negotiate the current financial straits without something spinning out of control. Finally, I note that the Vix index (implied equity volatility) continues to reflect an above-average level of risk-aversion.

I do see some light at the end of this gloomy tunnel, however, and I expect it will brighten over the course of the year as the presidential elections focus the country's attention on what has caused our economic funk and how best to get out of it. If there is any good that has come out of the trillions of dollars of wasteful government spending in the past several years, it is the growing realization that government spending can not stimulate the economy, and only does more harm than good, by squandering precious resources and promoting crony capitalism. It's been a very expensive lesson in how Keynesian economics not only doesn't work but doesn't make sense to begin with. Bureaucrats cannot spend money more efficiently than the people who earn the money, and politicians cannot make better investment decisions than private enterprise. Industrial policy has never worked anywhere, and we see multiple examples of its failure almost every day in the headlines (e.g., Solyndra).

I believe the elections this year will reaffirm the message of the 2010 elections: the electorate wants less government, not more; lower and flatter taxes, not higher; a simpler tax code, not more complexity. The changes might not be dramatic or immediate, but the political winds are blowing to the right, and over time this will push policies in a direction that will be more favorable/less destructive to growth. I believe that government spending can be throttled back without harming the economy; indeed, I think that a reduction in the size of government can actually boost economic growth, because it means that the market and the private sector will regain a measure of control over the decisions of how best to utilize the economy's scarce resources.

I see important signs that the economy has undergone substantial adjustments that now pave the wave for continued growth: businesses are firing fewer and fewer people since they have already cut costs to the bone; productivity and profits have improved measurably; jobs have been growing for almost two years; housing prices have reversed all of their previous excess; residential construction is beginning to come back to life; banks are once again lending, and at a faster pace; the Fed has ensured that there is no shortage of money; business investment is on the rise. Left to its own devices, and given enough time to adjust to adversity, the U.S. economy is perfectly capable of growing—and that is what is happening now. No reason this can't continue.

One key assumption I'm making is that sovereign debt defaults in Europe—which appear quite likely to happen—are not likely to be as destructive to growth as the market assumes. (Imagine the boom in risk asset prices if the Eurozone sovereign debt crisis were to disappear overnight, and you understand what a pall this has cast over all markets.) I've explained why defaults shouldn't be catastrophic here, but the short answer is that debt defaults don't destroy demand or productive capacity, and they are better thought of as a zero-sum game in which wealth is transferred from creditors to defaulting debtors. Many banks may fail as a result of major defaults, but banks can be replaced and/or recapitalized, and there is no shortage of capital in the world to do so. The losses that are eventually confirmed by a default have, in an economic sense, already occurred—they are water under the bridge. Defaults will also dictate that bloated Eurozone governments have no choice but to change their ways, and that will improve the prospects for future growth. They also will likely help the U.S. understand that we cannot continue with our spend-and-borrow ways.

I am not a huge optimist about the prospects for U.S. economic growth over the course of this coming year, because I see important headwinds to growth continuing: bloated government spending which appropriates the economy's scarce resources for inefficient and unproductive ends; the promise of higher tax burdens implicit in the soaring federal debt; huge regulatory burdens; and tremendous uncertainty surrounding the long-term implications of the Federal Reserve's massively bloated balance sheet. In short, I think the economy is growing despite all the supposed "help" from fiscal and monetary policy stimulus. I think that's because the U.S. economy is inherently dynamic and most people have a strong desire to work hard and get ahead. If the economy grows only 3-4% this year, I think the market will be pleasantly surprised, even though 3-4% growth won't result in any meaningful decline in the unemployment rate. Even modest growth would be much better than what the market is currently expecting, and that makes me an optimist in a relative sense because the market is so clearly pessimistic.

So, having outlined my assumptions—which are the key to any forecast—here goes:

The economy will grow by 3-4% in 2012, and if there is a surprise it will be on the high side. I think this is a safe prediction, since jobs currently are growing at a 1.7% annualized pace, and the productivity of the average worker tends to average about 2% a year. Growth could pick up towards the end of the year if the market gains confidence that fiscal policy will be more conducive to growth in the future, and that Eurozone defaults are not likely to deal a lethal blow to the global economy.

Inflation will moderate in the first half of the year, but will be roughly unchanged or somewhat higher by the end of the year.

The Fed will not engage in another round of quantitative easing because it will not be necessary or justifiable. If the economy grows 3-4%, inflation doesn't collapse, and Eurozone defaults don't bring about the end of the world as we know it, the Fed will be hard-pressed to justify another round of QE no matter what form it might take. Before the year is out, I think the issue of how to unwind previous quantitative easings will be more important than whether we need another round of quantitative easing.

Interest rates are likely to rise across the board as the outlook for growth improves. It is inconceivable to me that any improvement in the long-term outlook for the economy would not be accompanied by higher interest rates.

The housing market is likely to improve gradually over the course of the year. I think this is a process that is already underway, but it's very gradual. Residential construction is slowly improving, and although housing prices have yet to make a definitive bottom, I think we'll see more evidence of one as the year progresses.

MBS spreads are likely to widen over the course of the year. (I'm repeating last year's forecast here.) The main impetus for wider MBS spreads next year is likely to come from an across-the-board increase in the extension risk of MBS as Treasury yields rise. Mortgages, which currently behave like intermediate-maturity bonds, are at risk of becoming long-term bonds as interest rates rise and refinancing dries up.Equity prices are likely to rise by 10-15%. Even if, as I suspect, the growth in corporate profits slows down, there is plenty of room for an expansion of equity multiples driven by improving confidence/receding fears.

Investment grade, junk, and emerging market bonds are likely to deliver decent returns. If Treasury yields rise, it will be because the economic outlook is improving, and that will mean lower default rates. Thus there is plenty of room for credit spreads to contract if Treasuries run into trouble. Even if we remain in a muddle-through scenarios, spreads—particularly of the high-yield variety—are generous and offer a substantial cushion against defaults.

Commodity prices are likely to rise. This follows from my belief that activity is severely depressed by fears of a sovereign debt crisis, and that these fears should dissipate or prove exaggerated. It also is a bow to the very accommodative nature of monetary policy around the world.

Emerging market economies are likely to improve.

Gold prices are likely to be very volatile, with the potential for a major decline. I think gold has already priced in the expectation of so many bad things (e.g., a big increase in inflation, a global depression, collapsing currencies) that any improvement in the outlook should convince investors that equities and corporate bonds offer much more attractive long-term returns than gold.

The dollar is likely to rise as the prospects for the U.S. economy improve relative to other developed economies. The dollar is still quite weak against most currencies from an historical and inflation-adjusted perspective.